Schaeffer's Outside the Box Blog
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Here's a news flash for anyone trapped in a well or a cave (or a New Jersey blackout) over the past month. We have a Looming Fiscal Cliff that's … I guess … looming. Not sure what's beyond this looming Fiscal Cliff? Turn on financial TV for six minutes -- any six minutes -- and you'll learn about it. Warning though: Don't play a drinking game that requires you to consume something every time a guest says "Fiscal Cliff" or "Looming Fiscal Cliff" or just curls up into a ball because he can't concentrate enough to give a coherent answer to a question, so long as we have a Looming Fiscal Cliff.

Long story short: our political leaders need to agree to some package of higher tax revenues and lower spending, otherwise we go over the Fiscal Cliff and automatically incur … higher tax revenues and lower spending. If it all sounds pre-ordained, well, I guess there's some uncertainty because company CEOs are frozen because normally everything is 100% certain going forward … but not now.

So here's my prediction. It will seem like an agreement is near. Then it won't. Then it will again. Then it won't again. Then the deadline will approach and perhaps they won't agree to anything by the deadline and then nothing cosmic will happen. By that time, though, the market will have discounted much of this and if in fact we do take a hit, it happens sooner rather than later.

All I know is, my head will explode if I hear "Looming Fiscal Cliff" 400 times per day between now and January.

The options market does not appear nearly as worried as the pundit class. As we noted last week, the CBOE Market Volatility Index (VIX) has acted quite poorly. That doesn't mean we won't actually see a market melt; it just means the market is not particularly afraid of one right now. Options markets are of course often wrong, and in fact I find it bearish on the margins that there is little fear, if for no other reason than the market has already acted poorly.

But perhaps we have a VIX pop looming around the next corner. That's not the end of the world, either. Mr. Black Swan Nassim Taleb has an interesting article on the subject in the Wall Street Journal, titled "Learning to Love Volatility:"

Fragility is the quality of things that are vulnerable to volatility. Take the coffee cup on your desk: It wants peace and quiet because it incurs more harm than benefit from random events. The opposite of fragile, therefore, isn't robust or sturdy or resilient—things with these qualities are simply difficult to break.

To deal with black swans, we instead need things that gain from volatility, variability, stress and disorder. My (admittedly inelegant) term for this crucial quality is "antifragile." The only existing expression remotely close to the concept of antifragility is what we derivatives traders call "long gamma," to describe financial packages that benefit from market volatility. Crucially, both fragility and antifragility are measurable.

He adds five suggestions to deal with the Coming Volatility Super Storm, but let's just stick with the one right above, "long gamma."

Quite simply, you can go long gamma in options via straddles and strangles. In the more abstract sense he refers to, "long gamma" likely also means long VIX futures or VIX derivatives or any other financial asset (thinking CDS offhand) that stands to benefit from an overall uptick in fear and volatility.

If nothing else, you're exactly paying a fortune for options here. They're mediocre on both an absolute price basis and a relative basis to current realized volatility.

So that's my suggestion to the Pundit Class. Less Fiscal Cliff fretting, more option buying.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.

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